Passive income is all about building a reliable second income stream, and the FTSE 100’s British American Tobacco (LSE: BATS) is built for exactly that.
Its dividend yield is consistently market-beating, and the cash flows behind it remain some of the most dependable in the leading index. There is also a major gap between its price and ‘fair value’, which could provide share price gains.
So what sort of returns am I looking at?
Dividends set to rise?
The firm’s current dividend yield is 5.5%, based on the 240.24p 2025 payout and the present £46.02 share price. That is way more than the FTSE 100 average of 3.1% and the FTSE 250’s 3.4%.
These returns can change, of course, as share prices and annual dividends alter. But analysts project that British American Tobacco will increase its dividends to 251.2p this year, 259.2p next year, and 269.8p in 2028.
These would generate respective dividend yields of 5.8%, 6%, and 6.2%.
How much in returns over time?
So, another £20,000 holding in the stock would make me £17,119 in dividends after 10 years, on the forecast 6.2% as an average.
The figure also includes the payouts being reinvested into the shares to harness the full turbocharging power of dividend compounding.
On the same basis, the returns would rise to £107,861after 30 years — the end of the standard long-term investment cycle. That would mean the holding’s total value (including the £20,000 stake) would be £127,861.
And that would deliver a yearly income of £7,927!
What about share price gains as well?
Historically, the price of a share tends to converge to its fair value. This reflects the underlying long-term business fundamentals rather than the short-term factors driving the price.
Discounted cash flow (DCF) analysis can identify the fair value of any stock by projecting future cash flows and discounting them back to today. Greater uncertainty in those forecasts will increase the discount applied. And differing assumptions sometimes here can produce varying DCF outcomes from analysts.
Using my own assumptions — including an 8.7% discount rate — British American Tobacco appears 32% undervalued at its current £43.37 price.
That suggests a fair value of £63.78. So, if markets continue to converge toward fair value, this will mean the £20,000 holding being worth £29,403!
Is the underlying business solid?
Ultimately, the long‑term investment case rests on steady earnings growth, and here the outlook remains solid. Analysts forecast these will grow by an annual average of 4.5% over the medium term at least.
A risk here is a further tightening in regulatory pressure on tobacco products, which could squeeze margins. Another is any delay in the firm’s transition towards next‑generation products, which could affect cash flow growth.
That said, the company forecast 4%-6% adjusted operating profit growth and 5%-8% adjusted diluted earnings per share growth for 2026 in its 2025 annual results.
My investment view
I already hold shares in the firm, based on its solid earnings growth outlook. This should keep pushing its dividends up — and its share price to fair value — over time, in my view.
Consequently, I will be adding to my holding very soon. And my attention has also recently been captured by a couple of other deeply undervalued stocks offering very high dividend yields too.
Should you invest £5,000 in British American Tobacco P.l.c. right now?
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Simon Watkins owns shares in British American Tobacco.
